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Monday, May 13, 2013

How to Spot & Time Stock Market Tops

Since the middle of April everyone and including their grandmother seems to have been building a short position in the equities market and we know picking tops or bottoms fighting the major underlying trend is risky business but most individuals cannot resist.

The rush one gets trying to pick a major top or bottom is flat out exciting and that is what makes it so darn addicting and irresistible. If you have ever nailed a market top or bottom then you know just how much money can be made. That one big win naturally draws you back to keep doing it much like how a casino works. The chemicals released in the brain during these extremely exciting times are strong enough that even the most focused traders fall victim to breaking rules and trying these type of bets/trades.

So if are going to try to pick a top you better be sure the charts and odds are leaning in your favor as much as possible before starting to build a position.

Below are a few charts with my analysis and thoughts overlaid showing you some of the things I look at when thinking about a counter trend trade like picking a top within a bull market.

Utility Stocks vs SP500 Index Daily Performance Chart:

The SPY and XLU performance chart below clearly shows how the majority of traders move out of the slow moving defensive stocks (utilities – XLU) and starts to put their money into more risky stocks. This helps boost the broad market. I see the same thing in bonds and gold this month which is a sign that a market top is nearing.

That being said when a market tops it is generally a process which takes time. Most traders think tops area one day event but most of the times it takes weeks to unfold as the upward momentum slows and the big smart money players slowly hand off their long positions to the greedy emotion drove traders.

Look at the chart below and notice the first red box during September and October. As you can see it took nearly 6 weeks for that top to form before actually falling off. That same thing could easily happen again this time, though I do feel it will be more violent this time around.

SPY ETF Trading Chart Shows Instability and Resistance:

Using simple trend line analysis we see the equities market is trading at resistance and sideways or lower prices are more likely in the next week or two.

Stocks Trading Above 150 Day Moving Average Chart:

This chart because it’s based on a very long term moving average (150sma) is a slow mover and does not work well for timing traded. But with that said it does clearly warn you when stocks are getting a little overpriced and sellers could start at any time.

General rule is not to invest money on the long side when this chart is above the 75% level. Rather wait for a pullback below it.

Stocks Trading Above 20 Day Moving Average Chart:

This chart is based on the 20 day moving average which moves quickly. Because it reacts quicker to recent price action it can be a great help in timing an entry point for a market top or bottom. It does not pin point the day/top it does give you a one or two week window of when price should start to correct.

How to Spot and Time Stock Market Tops Conclusion:

As we all know or will soon find out, trading is one of the toughest businesses or and one of the most expensive hobbies that one will try to master. Hence the 95-99% failure rate of individuals who try to understand how the market functions, position management, how to control their own emotions and to create/follow a winning strategy.

With over 8000 public traded stocks, exchange traded funds, options, bonds, commodities, futures, forex, currencies etc… to pick from its easy to get overwhelmed and just start doing more or less random trades without a proven, documented rule based strategy. This type of trading results in frustration, loss of money and the eventual closure of a trading account. During this process most individuals will also lose friends, family and in many cased self-confidence.

So the next time you think about betting against the trend to pick a top or a bottom you better make darn sure you have waited well beyond the first day you feel like the market is topping out. Stocks trading over the 150 and 20 day moving averages should be in the upper reversal zones and money should be flowing out of bonds and other safe haven/defensive stocks to fuel the last rally/surge higher in the broad market.

Also I would like to note that I do follow the index futures and volume very closely on both the intraday and daily charts. This is where the big money does a lot of trading. Knowing when futures contracts are being sold or bought with heavy volume is very important data in helping time tops and bottoms more accurately. And the more experience you have in trading also plays a large part in your success in trading tops and bottoms.